Monday, August 17, 2009

Gorton Expands His Haircut Run Theory

Gary Gorton wrote an interesting piece (Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007) documenting that haircuts on a variety of Repo collateral went up severely in the financial crisis, and may be the essence of how this crisis accelerated. He has two papers that expand this idea, and the data underlying it. I think he makes an excellent point, and like how he clarifies his position, even at the risk of repeating himself.

In Securitized Banking and the Run on Repo, Gorton and colleague Andrew Metrick (great economist name) go over the basic idea of how repo haircuts relate to a bank run. He notes the crisis starts in July 2007, just when several AAA ABX-HE (subprime housing) tranches started trading below par.

At that point people realized these assets were not merely a normal bump in default rates, because anytime a large AAA CDO trades below par, you basically have a catastrophe alert. Given that even today commenters do not agree on what was wrong, the failure of informationally insensitive assets caused every informationally insensitive asset to trade as if a junk bond. That is, the problem could have been merely poor underwriting, but it could have been due to something else: Fed policy (Taylor), excessive confidence in models (Taleb), CDO assumptions (Felix Salmon), everything (Roubini), hubris (Tett), h government (Woods), and bubbles (Shiller).

Now, these explanation affect much more than subprime housing, and given the prominence of these hypotheses they are concerns reflected in the general investing public. I sense that many investors changed from taking any AAA rated securities as a given, to going over all the things that could go wrong, which using the minimax principle generates really low prices.

So, with the AAA for subprime went bad, all AAA ABS was suspect, haircuts rose, and through the mechanism described by Gorton, a reduction in the monetary base similar to if customers withdrew deposits. A modern bank run via repo haircuts rising.

If the idea of repo haircuts is not clear to you, no worries. Gorton and Metrick have a short paper, Haircuts, explaining that for all you haircut noobs.

7 comments:

The paper identifies the hit due to increases in repo haircuts. But another key factor was changes to the funding spread. The business model of many SIVs depended on a stable LIBOR rate, otherwise it wasn't safe to lever up the AAA securities. Once LIBOR started going wild, the funding costs for the SIVs exceeded the coupons on their investments, so the business model was unsustainable, and investors stopped supporting the SIVs. So both sides of the balance sheet were squeezed.

So many things blew up, it will be difficult to describe the crisis in a simple catchphrase such as "Run on Repo". For example, there were blow-ups with ARS and monolines at the time, neither of which is captured by "run on repo".

Gary Gorton is hardly writing objective research. He is writing/creating exculpatory evidence a la Myron Scholes. Scholes is viewed by many as a broken record who just can't accept the fact that he missed something during his LTCM run (as well as at his most recent gig). His ideas worked except for the existence of market imperfections (which can be assumed on average to have an expected value of zero...and therefore can be ignored ). Same thing with Gorton. Gorton was paid by AIGFP to research products to peddle. Gorton is like Scholes, he just can't fess up that he messed up...Upton Sinclair wrote "it is difficult to get a man to understand something when his job depends on not understanding it"... except in the case of GG one might change the quote to "it is difficult to get GG to understand something when his ego depends on not understanding it"...

@Anonymous: At first glance, Gorton's paper looks ok as far as it goes. I was monitoring both ABX and LIB-OIS at the time, although it wasn't clear what to do when LIB was fixed but not traded.

Just because Gorton has skin in the game doesn't mean his research should be discarded- much good research has "impure" motives...

However, for another interesting comment on the effect of repo haircuts, below are comments by Mark Carey (Advisor, International Finance, Federal Reserve Board, Washington DC) in the latest Geneva Report:

"The main problem in the current crisis was not the margin spiral as much as the fact that banks were shedding assets, often at fire-sale prices, and that they were hoarding liquidity out of fear of a run. Liquidity was necessary to stop the run and assets were being shed either to window dress the balance sheet and enable the bank to claim that they had no asset-backed securities, or because they were trying to stay above the run threshold."